Design Flaws in MFI Operations in India

The author of this article can be contacted by email at seemassahai(at the rate)gmail(dot)com

Design flaws in the Operations of Microfinance Institutions in India

Micro finance has been recognized as an instrument for attaining UN Millennium Goal of poverty alleviation by multi lateral agencies like World Bank as well as by governments across board. Indian government has also pinned great hopes on micro finance. 12th five year plan specifically mentions that micro finance will help generate employment by providing affordable financial products for fixed capital formation in household sector. Here it needs to be noted that although micro finance includes financial services like thrift, insurance, credit and remittance, credit remains the most emphasized service by clients and regulators alike.

India has two channels of Micro finance- Self Help Group- Bank Linkage Programme (SBLP), and Micro Finance Institutions (MFI) led microfinance. This article focuses on services provided by MFIs. Within short span MFIs have surpassed Regional Rural Banks (RRB) and Commercial Banks in terms of number of small loan accounts (M- CRIL Micro finance Review 2011). Even after the crisis which started in 2010 MFIs have outpaced SBLP in annual growth in terms of number of accounts. That explains why all good and bad aspects of micro finance are being associated with MFIs by clients and public alike.

Government has recognized the potential of MFIs at various levels. Former Finance Minister Pranab Mukherjee emphasized the role of MFIs in financial inclusion (Budget Speech, 2011). Micro finance Institutions (Development & Regulation Bill) 2012 introduced by government also aims at encouraging MFI operations. With this supportive environment MFIs are likely to grow. With MFIs showing a growth rate of 68% per annum in unique client base from 2005- 2010 there can be no doubt about the fact that MFIs have played crucial role in bringing about financial inclusion.

A microfinance client whose successful sewing business was started with a micro loan.

But this is the success story of MFIs and not that of the borrowers. Growth of MFI and growth of borrowers do not necessarily go together. Positive impact of micro finance on clients’ income has yet to be proved. There is no strong conclusive evidence world over that micro finance has created substantial positive impact on its clients’ income. The panel data research of Bangladesh that is the basis of policy on micro finance in many countries including India has also been questioned recently for its methodology.

Moreover a look at general operational practices of major ‘for profit’ MFIs (which altogether account for 85% of business) in India show that these are not designed to materialise the lofty claims of these MFIs.

To begin with MFIs provide credit to only those units which are already in business for more than a year or two. So the very idea of providing credit to poor so that they can invest in productive asset and earn livelihood is defeated. Only those who have already invested and successfully run the unit get credit. This surely is a prudent business sense to lend to running units but it is not the raison d’être of MFIs. This policy leaves the theoretical client of micro finance (those who need money to invest in productive assets) out. Mostly the credit is used by clients to realize working capital requirements such as procuring raw material (in case of manufacturing) or replenishing the stock (in trading), or upgrading the shop (in service industry) or to fulfil some personal needs. Also, the assessment of the clients is done on the basis of their present repayment capacity and not on the basis of projected income generation. So, one should already be doing well to get a loan to better oneself.

Additionally, the basic criterion for selection of borrowers in all major MFIs mandates that the borrower must be permanent resident of the place and should own a house. This categorically leaves out the very poor. This practice again defies the stated objective of micro finance of providing credit to poor to earn livelihood. Few MFIs have focused programs for ultra-poor on some specific locations but those are exceptions and not the rule. This approach limits the number of eligible borrowers. These comparatively fewer eligible borrowers are targeted by all lenders leading to multiple borrowings.

Also MFIs offer a common product- fixed credit amount and fixed tenure to all types of enterprises. So whether one is a tailor or welder or vegetable vendor or carpenter or photo copier one gets a fixed amount of credit repayable in a fixed time period. There is no assessment of business needs of different types of activities like gestation period, investment requirement, or even scope of the activity. A photo copying machine for example may cost around a Lac and a sewing machine may cost just 5000 but both units are given similar credit amount ranging from 10 to 20 thousand. Similarly level of enterprise potential is not taken into account. It is very likely that units which have established themselves are in a take off stage and if given proper financial support can grow and generate more employment. But that does not appear to be the scope of MFIs.

Again a small amount of Rs 10-20 thousand is not sufficient for starting most business activities. While activities like tailoring, or knitting where only one time investment in machine is required can be started all other activities require higher investment. Even an average quality buffalo costs 30 to 40 thousand. Incidentally, this amount is not even sufficient to cater to a running and growing enterprise where entrepreneurs have to depend on private sources for peak season work.

Further all the trainings and business advisory services are mostly supply driven without taking into account the needs of the enterprise. There is neither any training nor any support in the form of market linkage or market information- these exist as an exception and not as a rule. Even government institutions for capacity building and providing market linkages are absent on the ground- at least borrowers are not aware of them even if they exist.

Further, Micro finance sector is dominated by ‘for profit’ MFIs or NBFC MFIs. Many of these MFIs started as NGO involved in developing clients but in the hay days of the sector many MFIs went straight into the business of providing micro credit to borrowers circumventing the stated route. It was not their business to develop clients to be an entrepreneur. Even those MFIs which started as NGOs got busy into providing credit and put the work of client development on the back burner. This disconnect of MFIs and clients has been recognized as an important reason for the micro finance crisis that erupted in India in 2010.

Above said does not aim at negating the positive role played by MFIs. Not only MFIs are successful in financial inclusion, it has also been proved by research that if micro finance has not created a very positive impact it has not created a negative impact either. It has definitely resulted in consumption smoothening. Also, these small loans are welcome by clients because in a perpetual state of resource crunch this credit helps in sailing through many problems. In fact being easily available and repayable in easy installment it should be given for consumption purpose as well (presently it is given for productive purpose only). Right now clients have to depend upon private sources of credit like relatives and money lenders for consumption loans that are very costly.

To conclude it can be said that MFI’s are a good source of financial inclusion but they have got certain limitations. Policy of employment generation through MFI has to focus on financial inclusion for those beyond the eligibility criteria of MFI’s, and also on creating an enabling environment for borrowers like capacity building and market linkages for clients. Government can not fully outsource employment generation to MFI’s.

The author of this article can be contacted by email at seemassahai(at the rate)gmail(dot)com

2 comments

Excellent article by the author. Author has reflected the exact picture of the sector, nothing more , nothing less. Should be pointer/must read material for the development sector /policy makers.

g k agrawal / March 14, 2013

Interesting observations/findings by the author ms. Seema Sahai. better to pursue findings for corrective/remedial action through NABARD. Findings can be shared with other MF practioners through the fora of UN MF Solution Exchange